Selling Quality Holdings
Features, by Mark Robertson, Managing Partner July 20th, 2005
It's the total portfolio expectations that matter and all decisions should reflect that.
View the article as a pdf file.
Chris Johnson asks, "If you have a ‘high quality’ stock in your portfolio with a low expected total return, is it time to sell? Or do you hold the stock keeping the quality of the portfolio high and depend on new investments to boost overall portfolio return?
"Using NAIC’s Stock Selection Guide, a company can show very limited upside (upside / downside ratio of 0.5 or less for example), very low expected five year total return (3% to 4%) and still be a quality company.
“This is something I struggle with in my own portfolio as well as clubs where I participated. How do others achieve this balance? Do you use strict rules about return or quality?”
“Hold on to your leaders.” “Let your winners run.” “Pull the weeds and water the flowers.” “That stock has been very good to us. How can we even — perish the thought — think of selling it?”
How many of us have heard or spoken those words?
Chris Johnson is right. He seems to yearn for methods that will provide some distance from the emotion we often succumb to when investing in stocks. During a recent investment club visit, I heard virtually every one of those quotes and expressions during a discussion of Chico’s FAS. So we’ll start with the first question and answer, “It depends.”
Depends on what? The answer is that it depends on many things, including the characteristics of the investment club or the personal risk traits for individual portfolios. It depends on the specific projected annual return for the stock under consideration for selling. It depends on the overall projected annual return for the club portfolio. Let’ s get specific, using Chico’s and a sample club portfolio.
Chico’s and “The Band”
What is a reasonable outlook for projected annual return for Chico’s? All of the underlying assumptions are displayed on the accompanying Equity Analysis Guide (EAGLE) for Chico’s.
The sales growth forecast (based on the Value Line company report dated 5/13/2005) is 13.4%. Chico’s has a powerful track record in profitability with no signs of weakness. The projected net margin has been left at 13.6% in the long-term forecast. Shares outstanding have been adjusted by observing the net profit and EPS forecasts in the VL report to 177.0. The projected average P/E has been left at 20x, although the PELT analysis of the women’s apparel sub-industry suggests that a slightly higher P/E (26.1x) could be justified.
Chico’s is, with fairly few questions, a recognized leader in its group with strong growth and profitability expectations. The quality rating is 79.6 (Excellent) buoyed by Chico’s strong relative growth and profitability. The financial strength rating is B++ and EPS predictability relatively high.
It is clear that Chico’s delivers a favorable influence on the overall quality rating of the portfolio.
But the question now revolves around what kind of influence does Chico’s have on the projected returns for the entire portfolio. Buying and selling decisions should generally be evaluated in the context of the total portfolio.In this case, the equity analysis suggests that CHS has a projected annual return of negative 3.3%. Raising the projected growth rate to, for example, 15% and the future average P/E to 24x still results in a projected annual return of 2.4%. This would still be less than the current yield on 13-week treasuries (3.18%) and I’d be inclined to sell the position even BEFORE going shopping for a replacement. The projected returns under optimistic assumptions are still less than short-term money market rates of return.
I should first point out that this type of overvalued situation is relatively rare. In the average portfolio of 12-20 stocks, this condition seems to occur very infrequently. In most cases, years may go by without this condition materializing.
When it does, it is always a hard pill to swallow. Our vision is jaundiced by those “genius-bestowing returns” that we’ve experienced and we have a great deal of faith in the management strength of our holding. We still want to talk about this stock when we sit in the chair at the barber or hair salon. Chico’s is no exception with its excellent quality rating.
And here’s where the crisis of confidence always sets in. Because of the strong trailing performance, we find it hard to accept that our optimistic assumptions deliver a low projected return. The best tool that we have for successful long-term investing is careful consideration of our forecasts. Ignoring the low projected return and “tolerating” Chico’s in the portfolio under these conditions is quite simply, settling for compromised results. We have a choice to make. We can either believe the reduced expectations and take action to maintain the portfolio or we can hope for some sort of unprecedented miracle that will avoid settling for less.
Most long-term investors seek to outperform the stock market over the long term by a defined advantage. Many of us seek to exceed the returns of the total stock market by 5-10%.
At the time of this article, the median projected annual return for the companies followed by Manifest Investing is approximately 11%.
This provides a guideline for us and “suggests” that the overall projected annual return of our portfolios should be maintained at a minimum of approximately 16%.
This sample club has an overall PAR of 13.0%. Maintenance is required. This is the methodology followed for the Tin Cup model portfolio demonstration for the period 1995-present.
The club would be well-advised to gauge which sectors are missing from the mix and to go shopping for a replacement for CHS. As an example, selling CHS and replacing it with Linear Technology (LLTC) would boost the overall portfolio PAR to 16.0%. See the BEFORE and AFTER portfolio characteristics in the accompanying dashboards.
Un-Leashing Quality
A quality company like Chico’s has earned a long leash. When making sell decisions, I think it makes sense to have a “slower trigger” (tolerating a lower PAR) for high-quality companies. In some cases, for lower-quality companies, the trigger should be substantially greater than short-term yields. At the end of the debate, it’s the total portfolio expectations that matter and all decisions should reflect that.
BEFORE. Sample Club Portfolio (7/19/2005.) This dashboard displays the key fundamentals for the portfolio. We note that Chico’s has a projected annual return (PAR) of -3.3% and the overall PAR is 13.0%. Theoverall sales growth is within acceptable ranges at 11.6% and the overall projected average P/E is in good standing at 22.1×. The portfolio containsa number of blue chip leaders and the overall MANIFEST quality rating (ranges from 0-to-100, >65 = Excellent) is quite strong at 75.2 (Excellent.) The Chico’s holding accounts for $3140 of total assets of $23,018.Sources: Manifest Investing, Value Line
AFTER. Sample Club Portfolio (7/19/2005.) This dashboard displays the key fundamentals for the portfolio after selling the Chico’s stake and replacing it with Linear Technology. The projected annual return (the primary design characteristic) has been restored to 16.0%. The sales growth is still solid at 12.0% and the quality rating, although slightly lower, is still within acceptable ranges at 73.5. Sources: Manifest Investing, Value Line